CIMAFundamental of Business Economics Study Text - Decrypted

by abruptsharp at www.free-ebook-download.
net
Certificate Paper C4
FUNDAMENTALS OF
BUSINESS ECONOMICS
For assessments in 2010 and 2011
Study Text
In this February 2010 edition

• A user-friendly format for easy navigation
• Regular fast forward summaries emphasising the key points in each
chapter
• Assessment focus points showing you what the assessor will want
you to do
• Questions and quick quizzes to test your understanding
• Question bank containing objective test questions with answers
• A full index
BPP Learning Media's i-Pass product also supports this paper.

FOR ASSESSMENTS IN 2010 and 2011
by abruptsharp at www.free-ebook-download.net
First edition June 2006
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Third edition February 2010
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ii
Contents Page
Introduction
The BPP Learning Media Study Text – The BPP Learning Media Effective Study Package – Help yourself
study for your CIMA assessment – Learning outcomes and syllabus – The assessment – Tackling
multiple choice questions – Tackling objective test questions – International terminology
Part A The goals and decisions of organisations

1 The economic problem ...............................................................................................................................................................3
2 Economic systems and organisations .........................................................................................................................................9
3 Theory of costs .........................................................................................................................................................................39
Part B The market system and the competitive process

4 Price determination – The price mechanism .............................................................................................................................65
5 Elasticities of demand and supply.............................................................................................................................................93
6 Market failures, externalities and intervention .........................................................................................................................119
7a Market structures – Perfect competition and monopoly ..........................................................................................................135
7b Market structures – Monopolistic competition, oligopoly and duopoly ..................................................................................163
8 Public policy and competition.................................................................................................................................................181
Part C The financial system

9 Finance and Financial Intermediaries......................................................................................................................................197
10 Credit and banking..................................................................................................................................................................225
Part D The macroeconomic context of business

11 National income accounting....................................................................................................................................................251
12 Macroeconomic theory ...........................................................................................................................................................273
13 Inflation and unemployment....................................................................................................................................................301
14 Macroeconomic policy............................................................................................................................................................317
15 International trade – The foreign exchange market..................................................................................................................361
16 International trade – The international economy .....................................................................................................................389
Appendix – Present value tables.......................................................................................................................................................419
Question bank .................................................................................................................................................................................423
Answer bank ....................................................................................................................................................................................443
Index ...............................................................................................................................................................................................455
Review form and free prize draw
iii
The BPP Learning Media Study Text
Aims of this Study Text
To provide you with the knowledge and understanding, skills and application techniques that you need if you are
to be successful in your exams
This Study Text has been written around the Fundamentals of Business Economics syllabus.
• It is comprehensive. It covers the syllabus content. No more, no less.
• It is written at the right level. Each chapter is written with CIMA's precise learning outcomes in
mind.
• It is targeted to the assessment. We have taken account of guidance CIMA has given and the
assessment methodology.
To allow you to study in the way that best suits your learning style and the time you have available, by following
your personal Study Plan (see page (vii))
You may be studying at home on your own until the date of the exam, or you may be attending a full-time course.
You may like to (and have time to) read every word, or you may prefer to (or only have time to) skim-read and
devote the remainder of your time to question practice. Wherever you fall in the spectrum, you will find the BPP
Learning Media Study Text meets your needs in designing and following your personal Study Plan.
To tie in with the other components of the BPP Learning Media Effective Study Package to ensure you have the
best possible chance of passing the exam (see page (v))
Learning to Learn Accountancy

BPP Learning Media's ground-breaking Learning to Learn Accountancy book is designed to be used both at the
outset of your CIMA studies and throughout the process of learning accountancy. It challenges you to consider
how you study and gives you helpful hints about how to approach the various types of paper which you will
encounter. It can help you focus your studies on the subject and exam, enabling you to acquire knowledge,
practise and revise efficiently and effectively.
iv Introduction
The BPP Learning Media Effective Study Package
Recommended
The BPP Learning Media Effective Study Package
period of use
From the outset and Learning to Learn Accountancy

throughout Read this invaluable book as you begin your studies and refer to it as you work through the
various elements of the BPP Learning Media Effective Study Package. It will help you to
acquire knowledge, practise and revise, efficiently and effectively.
Three to twelve Study Text

months before the Use the Study Text to acquire knowledge, understanding, skills and the ability to apply
assessment techniques.
Throughout i-Pass
i-Pass, our computer-based testing package, provides objective test questions in a variety of
formats and is ideal for self-assessment.
One to six months Practice & Revision Kit

before the assessment Try the numerous assessment-format questions, for which there are full worked solutions
where relevant prepared by BPP Learning Media's own authors. Then attempt the two mock
assessments.
From three months Passcards

before the assessment Work through these short, memorable notes which are focused on what is most likely to
until the last minute come up in the assessment you will be sitting.
Introduction v
Help yourself study for your CIMA assessment
Assessments for professional bodies such as CIMA are very different from those you have taken at college or
university. You will be under greater time pressure before the assessment – as you may be combining your
study with work. There are many different ways of learning and so the BPP Study Text offers you a number of
different tools to help you through. Here are some hints and tips: they are not plucked out of the air, but based on
research and experience. (You don't need to know that long-term memory is in the same part of the brain as
emotions and feelings - but it's a fact anyway.)
The right approach

1 The right attitude
Believe in yourself Yes, there is a lot to learn. Yes, it is a challenge. But thousands have
succeeded before and you can too.
Remember why you're doing it Studying might seem a grind at times, but you are doing it for a reason: to
advance your career.
2 The right focus
Read through the Syllabus and These tell you what you are expected to know and are supplemented by
learning outcomes Assessment focus points in the text.
3 The right method
The whole picture You need to grasp the detail - but keeping in mind how everything fits into
the whole picture will help you understand better.
• The Introduction of each chapter puts the material in context.
• The Syllabus content, Learning outcomes and Assessment focus
points show you what you need to grasp.
In your own words To absorb the information (and to practise your written communication
skills), it helps to put it into your own words.
• Take notes.
• Answer the questions in each chapter. You will practise your written
communication skills, which become increasingly important as you
progress through your CIMA assessments.
• Draw mindmaps.
• Try 'teaching' a subject to a colleague or friend.
Give yourself cues to jog your The BPP Learning Media Study Text uses bold to highlight key points.
memory • Try colour coding with a highlighter pen.
• Write key points on cards.
vi Introduction
4 The right review
Review, review, review It is a fact that regularly reviewing a topic in summary form can fix it in your
memory. Because review is so important, the BPP Learning Media Study
Text helps you to do so in many ways.
• Chapter roundups summarise the 'fast forward' key points in each
chapter. Use them to recap each study session.
• The Quick quiz is another review technique you can use to ensure that
you have grasped the essentials.
• Go through the Examples in each chapter a second or third time.
Developing your personal Study Plan

BPP Learning Media's Learning to Learn Accountancy book emphasises the need to prepare (and use) a study
plan. Planning and sticking to the plan are key elements of learning success.
There are four steps you should work through.
Step 1 How do you learn?
First you need to be aware of your style of learning. The BPP Learning Media Learning to Learn
Accountancy book commits a chapter to this self-discovery. What types of intelligence do you
display when learning? You might be advised to brush up on certain study skills before launching
into this Study Text.
BPP Learning Media's Learning to Learn Accountancy book helps you to identify what intelligences
you show more strongly and then details how you can tailor your study process to your preferences.
It also includes handy hints on how to develop intelligences you exhibit less strongly, but which
might be needed as you study accountancy.
Are you a theorist or are you more practical? If you would rather get to grips with a theory before
trying to apply it in practice, you should follow the study sequence on page (viii). If the reverse is
true (you like to know why you are learning theory before you do so), you might be advised to flick
through Study Text chapters and look at examples, case studies and questions (Steps 8, 9 and 10 in
the suggested study sequence) before reading through the detailed theory.
Step 2 How much time do you have?

Work out the time you have available per week, given the following.
• The standard you have set yourself
• The time you need to set aside later for work on the Practice & Revision Kit and Passcards
• The other exam(s) you are sitting
• Very importantly, practical matters such as work, travel, exercise, sleep and social life
Hours
Note your time available in box A. A
Introduction vii
Step 3 Allocate your time
• Take the time you have available per week for this Study Text shown in box A,
multiply it by the number of weeks available and insert the result in box B. B
• Divide the figure in box B by the number of chapters in this text and insert the
result in box C. C
Remember that this is only a rough guide. Some of the chapters in this book are longer and more
complicated than others, and you will find some subjects easier to understand than others.
Step 4 Implement
Set about studying each chapter in the time shown in box C, following the key study steps in the
order suggested by your particular learning style.
This is your personal Study Plan. You should try and combine it with the study sequence outlined
below. You may want to modify the sequence a little (as has been suggested above) to adapt it to
your personal style.
BPP Learning Media's Learning to Learn Accountancy gives further guidance on developing a study
plan, and deciding where and when to study.
Suggested study sequence

It is likely that the best way to approach this Study Text is to tackle the chapters in the order in which you find
them. Taking into account your individual learning style, you could follow this sequence.
Key study steps Activity

Step 1 Each numbered topic is a numbered section in the chapter.
Topic list
Step 2 This gives you the big picture in terms of the context of the chapter, the learning outcomes the
Introduction chapter covers, and the content you will read. In other words, it sets your objectives for study.
Step 3 Fast forward boxes give you a quick summary of the content of each of the main chapter
Fast forward sections. They are listed together in the roundup at the end of each chapter to provide you with
an overview of the contents of the whole chapter.
Step 4 Proceed methodically through the chapter, reading each section thoroughly and making sure
Explanations you understand.
Step 5 • Key terms can often earn you easy marks (and they are highlighted in the index at the
Key terms and back of the text).
Assessment focus • Assessment focus points state how we think the examiner intends to examine certain
points topics.
Step 6 Take brief notes, if you wish. Avoid the temptation to copy out too much. Remember that being
Note taking able to put something into your own words is a sign of being able to understand it. If you find
you cannot explain something you have read, read it again before you make the notes.
viii Introduction
Key study steps Activity
Step 7 Follow each through to its solution very carefully.
Examples
Step 8 Make a very good attempt at each one.
Questions
Step 9 Check yours against ours, and make sure you understand any discrepancies.
Answers
Step 10 Work through it carefully, to make sure you have grasped the significance of all the fast
Chapter roundup forward points.
Step 11 When you are happy that you have covered the chapter, use the Quick quiz to check how much
Quick quiz you have remembered of the topics covered and to practise questions in a variety of formats.
Step 12 Either at this point, or later when you are thinking about revising, make a full attempt at the
Question(s) in the Question(s) suggested at the very end of the chapter. You can find these at the end of the
question bank Study Text, along with the Answers so you can see how you did.
Short of time: Skim study technique?

You may find you simply do not have the time available to follow all the key study steps for each chapter, however
you adapt them for your particular learning style. If this is the case, follow the skim study technique below.
• Study the chapters in the order you find them in the Study Text.
• For each chapter:
– Follow the key study steps 1-2
– Skim-read through step 4, looking out for the points highlighted in the fast forward boxes (step 4)
– Jump to step 10
– Go back to step 5
– Follow through step 7
– Prepare outline answers to questions (steps 8/9)
– Try the Quick quiz (step 11), following up any items you can't answer
– Do a plan for the Question (step 12), comparing it against our answers
– You should probably still follow step 6 (note-taking), although you may decide simply to rely on the
BPP Leaning Media Passcards for this.
Introduction ix
Moving on...
However you study, when you are ready to embark on the practice and revision phase of the BPP Learning Media
Effective Study Package, you should still refer back to this Study Text, both as a source of reference (you should
find the index particularly helpful for this) and as a way to review (the Fast forwards, Assessment focus points,
Chapter roundups and Quick quizzes help you here).
And remember to keep careful hold of this Study Text – you will find it invaluable in your work.
More advice on Study Skills can be found in BPP Learning Media's Learning to Learn Accountancy book.
x Introduction
Learning outcomes and Syllabus
Paper C4 Fundamentals of Business Economics
This is an introduction to business economics and assumes no prior knowledge of the subject. It aims to provide
students with a knowledge of the fundamental economic and financial concepts necessary for conducting the role
of a management accountant, and underpins their studies towards attainment of the award of Chartered
Management Accountant.
The first section of the syllabus introduces the key concepts of business economics, including the fundamental
economic problem of how to allocate scarce resources to obtain the maximum possible benefit from them.
The second section looks at the way markets operate through the interaction of supply and demand. It also looks at
a range of different market structures, and considers situations where governments need to intervene to correct
market failures.
The third section introduces the financial system, and looks at the role of financial organisations in meeting the
financial requirements of businesses and individuals.
Finally, the fourth section looks at the way economies operate as a whole, and it looks at key issues such as
inflation, unemployment, government economic policies and international trade.
The syllabus addresses the fundamentals of the subject only and recognises that some economic systems (for
example stock markets and banking systems) vary from one area of the world to another. No knowledge of a
specific country’s systems is assumed, and the assessment will focus on the underlying principles of the subject
rather than the detail of any specific country’s systems.
Aims
This syllabus aims to test students' ability to:
• Distinguish the differing goals of organisations and identify how these differing goals affect the decisions
made by managers
• Illustrate how market economies function and identify the reasons for, and impacts of, government
involvement in economic activities
• Identify the role of financial institutions and markets in the provision of short and long term finance to
individuals, businesses and governmental organisations
• Identify how macroeconomic variables and government economic policies affect the organisation.
Assessment
The assessment is computer-based, lasting 120 minutes (2 hours) and comprising 75 compulsory questions.
Further reading
Although this Study Text is designed to provide all the information you need to tackle the C4 assessment, if you
want to read more widely around the subject of business economics we recommend you look at:
Sloman, J. (2007) Economics and the Business Environment, (2nd ed.), Pearson
Introduction xi
Learning outcomes and syllabus content
C4 A – The goals and decisions of organisations – weighting 20%

Learning outcomes
On completion of their studies students should be able to:
(i) Distinguish the goals of profit seeking organisations, not-for-profit organisations and governmental
organisations;
(ii) Compute the point of profit maximisation for a single product firm in the short run;
(iii) Distinguish the likely behaviour of a firm's unit costs in the short run and long run;
(vi) Illustrate the effects of long run cost behaviour on prices, the size of the organisation, and the number of
competitors in the industry;
(v) Illustrate shareholder wealth, the variables affecting shareholder wealth, and its application in management
decision making;
(vi) Identify stakeholders and their likely impact on the goals of not-for-profit organisations and the decisions of
the management of not-for-profit organisations;
(vii) Distinguish between the potential objectives of management and those of shareholders, and the effects of
this principal-agent problem on decisions concerning price, output and growth of the firm.
(viii) Describe the main mechanisms to improve corporate governance in profit seeking organisations.
Indicative syllabus content Covered in chapter
(1) The forms of ownership of organisations, by which we mean public, private and 1, 2
mutual, and their goals
(2) Graphical treatment of short run cost and revenue behaviour as output increases 3
(revenue and cost curves) and identification of point of short-run profit maximisation,
using graphical techniques, and from data.
(3) Long run cost behaviour and the impact of economies and diseconomies of scale 3
(4) Concept of returns to shareholder investment in the short run (ROCE and EPS) and long 2
run (NPV of free cash flows) leading to need for firms to provide rates of return to
shareholders at least equal to the firm's cost of capital.
(5) Calculation of impact on the value of shares of a change to a company's forecast cash 2
flows or required rate. (Note: Calculations required will be either perpetual annuity
valuations with constant annual free cash flows, or NPV calculations with variable
cash flows over three years.)
(6) Types of not-for-profit organisations (NPOs) and the status of economic 2
considerations as constraints rather than primary objectives in the long run.
(7) Role of stakeholders in setting goals and influencing decisions in NPOs and potential 2
ways of resolving differing stakeholder demands.
(8) The principal-agent problem, its likely effect on decision-making in profit seeking and 2
NPO organisations, and the concepts of scrutiny and corporate governance.
xii Introduction
C4 B – The market system and the competitive process – weighting 30%
Learning Outcomes
(i) Identify the equilibrium price in a product or factor markets likely to result from specified changes in
conditions of demand or supply;
(ii) Calculate the price elasticity of demand and the price elasticity of supply;
(iii) Identify the effects of price elasticity of demand on a firm's revenues following a change in prices;
(iv) Describe market concentration and describe the factors giving rise to differing levels of concentration
between markets;
(v) Describe market failures, their effects on prices, efficiency of market operation and economic welfare, and
the likely responses of government to these;
(vi) Distinguish the nature of competition in different market structures;
(vii) Identify the impacts of the different forms of competition on prices and profitability.
(1) The price mechanism: determinants of supply and demand and their interaction to 4
form and change equilibrium price.
(2) The price elasticity of demand and its effect on firms' revenues and pricing 5
decisions.
(3) The price elasticity of supply and its impact on prices, supply and buyers' 5
expenditure.
(4) Business integration: mergers, vertical integration and conglomerates. 3
(5) Calculation of market concentration and its impact on efficiency, innovation and 7b
competitive behaviour.
(6) Impact of monopolies and collusive practices on prices and output and role of 7a, 7b, 8
competition policy in regulating this.
(7) Factors causing instability of prices in primary goods markets (ie periodic and short 5
run inelasticity of supply, the cobweb or hog cycle) and the implications of this for
producer incomes, industry stability and supply and government policies to combat
this (eg deficiency payments, set-aside, subsidies)
(8) Impact of minimum price (minimum wages) and maximum price policies in goods 4
and factor markets.
(9) Positive and negative externalities in goods markets and government policies to deal 6
with these (including indirect taxes, subsidies, polluter pays policies and regulation).
(10) Public assurance of access to public goods, healthcare, education and housing. 6
(11) Public versus private provision of services (nationalisation, privatisation, contracting 8
out, public private partnerships).
Introduction xiii
C4 C – The Financial System – weighting 20%
Learning outcomes
(i) Identify the factors leading to liquidity surpluses and deficits in the short, medium and long run in
households, firms and governments;
(ii) Explain the role of various financial assets, markets and institutions in assisting organisations to manage
their liquidity position and to provide an economic return to holders of liquidity;
(iii) Identify the role of insurance markets in the facilitation of the economic transfer and bearing of risk for
households, firms and governments;
(iv) Identify the role of the foreign exchange market and the factors influencing it, in setting exchange rates and
in helping organisations finance international trade and investment;
(v) Explain the role of national and international governmental organisations in regulating and influencing the
financial system, and identify the likely impact of their policy instruments on businesses.
(1) The causes of short-term, medium-term and long-term lack of synchronisation 9
between payments and receipts in households (ie month-to-month cash flow, short-
term saving and borrowing, and longer-term property purchases and pensions
provision).
between payments and receipts in firms (ie month-to-month cash flow management,
finance of working capital and short-term assets and long term permanent capital).
between payments and receipts in governmental organisations (ie month-to-month
cash flow management, finance of public projects and long-term management of the
national debt).
(4) The principal contracts and assets issued by financial institutions and borrowers to 9
attract liquidity in the short, medium and long term (eg credit agreements, mortgages,
bills of exchange, bonds, certificates of deposit and equities)
(5) The roles and functions of financial intermediaries and the principal institutions and 9
markets in the financial system.
(6) The influence of commercial banks on the supply of liquidity to the financial system 10
through their activities in credit creation.
(7) Yield on financial instruments (ie bill rate, running yield on bonds, net dividend yield 10
on equity), relation between rates, role of risk, the yield curve.
(8) Influence of central banks on yield rates through market activity and as providers of 10
liquidity to the financial system.
(9) Principal insurance contracts available, and basic operation of insurance markets 9
including terminology (eg broking, underwriting, reinsurance).
(10) The role of foreign exchange markets in facilitating international trade and in 15
determining the exchange rate.
xiv Introduction
(11) Effect of exchange rates on the international competitiveness of firms (including 15
elementary foreign exchange translation calculations).
(12) Credit and foreign exchange risks of international trading firms and the use of letters 15
of credit, export credit guarantees and exchange rate hedging to manage these risks.
(13) Influences on exchange rates: interest rates, inflation rates, trade balance, currency 15
speculation.
(14) Governmental and international policies on exchange rates (ie exchange rate 15
management, fixed and floating rate systems, single currency zones) and the
implications of these policies for international business.
C4 D – The macroeconomic context of business – weighting 30%

Learning outcomes
(i) Explain macroeconomic phenomena, including growth, inflation, unemployment, demand management and
supply-side policies;
(ii) Explain the main measures and indicators of a country's economic performance and the problems of using
these to assess the wealth and commercial potential of a country;
(iii) Identify the stages of the trade cycle, its causes and consequences, and discuss the business impacts of
potential policy responses of government to each stage;
(iv) Explain the main principles of public finance (ie deficit financing, forms of taxation) and macroeconomic
policy (fiscal, monetary and supply side policies);
(v) Explain the concept of the balance of payments and its implications for business and for government policy;
(vi) Identify the main elements of national policy with respect to trade, including protectionism, trade
agreements and trading blocks;
(vii) Identify the conditions and policies necessary for economic growth in traditional, industrial and post-
industrial societies, and discuss the potential consequences of such growth;
(viii) Explain the concept and consequences of globalisation for businesses and national economies;
(ix) Identify the major institutions promoting global trade and development, and their respective roles.
(1) National Income Accounting identity and the three approaches to calculation and 11
presentation of national income (Output, Expenditure and Income).
(2) Interpretation of national income accounting information for purposes of time series 11
or cross-sectional evaluation of economic performance.
(3) The circular flow of income and the main injections and withdrawals. 11
(4) Illustration of changes to equilibrium level of national income using aggregate 12
demand and supply analysis.
(5) Government macroeconomic policy goals (low unemployment, inflation, external 13, 14
equilibrium and growth) and the effects on business of the government's pursuit of
these.
Introduction xv
(6) Types and consequences of unemployment, inflation and balance of payments 13, 16
deficits.
(7) The trade cycle and the implications for unemployment, inflation and trade balance 12
of each stage (recession, depression, recovery, boom).
(8) Government policy for each stage of the business cycle and the implications of each 12, 14
policy for business.
(9) The central government budget and forms of direct and indirect taxation. Incidence 14
of taxation (progressive, regressive) and potential impact of high taxation on
incentives and avoidance.
(10) Fiscal, monetary and supply side policies, including relative merits of each. 14
(11) Layout of balance of payments accounts and the causes and effects of fundamental 16
imbalances in the balance of payments.
(12) Arguments for and against free trade and policies to encourage free trade (eg bi- 16
lateral trade agreements, multi-lateral agreements, free trade areas, economic
communities and economic unions), and protectionist instruments (tariffs, quotas,
administrative controls, embargoes).
(13) Principal institutions encouraging international trade (eg WTO/GATT, EU, G8). 16
(14) Nature of globalisation and factors driving it (eg improved communications, political 16
realignments, growth of global industries and institutions, cost differentials).
(15) Impacts of globalisation (eg industrial relocation, emergence of growth markets, 16
enhanced competition, cross-national business alliances and mergers, widening
economic divisions between countries)
(16) Role of major institutions (eg World Bank, International Monetary Fund, European 16
Bank) in fostering international development and economic stabilisation.
xvi Introduction
The assessment
Format of computer-based assessment (CBA)
The CBA will not be divided into sections. There will be a total of seventy five objective test questions and you will
need to answer ALL of them in the time allowed, 2 hours.
Frequently asked questions about CBA
Q What are the main advantages of CBA?

A • Assessments can be offered on a continuing basis rather than at six-monthly intervals
• Instant feedback is provided for candidates by displaying their results on the computer screen
Q Where can I take CBA?

A • CBA must be taken at a 'CIMA Accredited CBA Centre'. For further information on CBA, you can
email CIMA at cba@cimaglobal.com.
Q How does CBA work?

A • Questions are displayed on a monitor
• Candidates enter their answers directly onto a computer
• Candidates have 2 hours to complete the Fundamentals of Financial Accounting examination
• The computer automatically marks the candidate's answers when the candidate has completed the
examination
• Candidates are provided with some indicative feedback on areas of weakness if the candidate is
unsuccessful
Q What sort of questions can I expect to find in CBA?

Your assessment will consist entirely of a number of different types of objective test question. Here are some
possible examples.
• MCQs. Read through the information on page (xix) about MCQs and how to tackle them.
• Data entry. This type of OT requires you to provide figures such as the correct figure for payables in a
statement of financial position.
• Multiple response. These questions provide you with a number of options and you have to identify those
which fulfil certain criteria.
This text provides you with plenty of opportunities to practise these various question types. You will find OTs
within each chapter in the text and the Quick quizzes at the end of each chapter are full of them. The Question
Bank contains more than one hundred and twenty objective test questions similar to the ones that you are likely to
meet in your CBA.
Further information relating to OTs is given on page (xx).
Introduction xvii
The Practice and Revision Kit for this paper was published in December 2009 and is full of OTs, providing you
with vital revision opportunities for the fundamental techniques and skills you will require in the assessment.
BPP Learning Media’s MCQ Cards were also published in February 2010 and provide you with 100 MCQs to
practice on, covering the whole syllabus.
xviii Introduction
Tackling multiple choice questions
In a multiple choice question on your paper, you are given how many incorrect options?
A Two
B Three
C Four
D Five
The correct answer is B.
The MCQs in your assessment contain four possible answers. You have to choose the option that best answers
the question. The three incorrect options are called distracters. There is a skill in answering MCQs quickly and
correctly. By practising MCQs you can develop this skill, giving you a better chance of passing the exam.
You may wish to follow the approach outlined below, or you may prefer to adapt it.
Step 1 Skim read all the MCQs and identify what appear to be the easier questions.
Step 2 Attempt each question – starting with the easier questions identified in Step 1. Read the question
thoroughly. You may prefer to work out the answer before looking at the options, or you may prefer
to look at the options at the beginning. Adopt the method that works best for you.
Step 3 Read the four options and see if one matches your own answer. Be careful with numerical
questions, as the distracters are designed to match answers that incorporate common errors. Check
that your calculation is correct. Have you followed the requirement exactly? Have you included every
stage of the calculation?
Step 4 You may find that none of the options matches your answer.
• Re-read the question to ensure that you understand it and are answering the requirement.
• Eliminate any obviously wrong answers.
• Consider which of the remaining answers is the most likely to be correct and select the
option.
Step 5 If you are still unsure make a note and continue to the next question.
Step 6 Revisit unanswered questions. When you come back to a question after a break you often find you
are able to answer it correctly straight away. If you are still unsure have a guess. You are not
penalised for incorrect answers, so never leave a question unanswered!
Assessment focus. After extensive practice and revision of MCQs, you may find that you recognise a question
when you sit the exam. Be aware that the detail and/or requirement may be different. If the question seems familiar
read the requirement and options carefully – do not assume that it is identical.
BPP Learning Media's i-Pass for this paper provides you with plenty of opportunity for further practice of MCQs.
Introduction xix
Tackling objective test questions
The vast majority of the questions in your assessment will be multiple choice questions. However, there may be a
small number of objective test questions.
What is an objective test question?

An OT is made up of some form of stimulus, usually a question, and a requirement to do something.
(a) Multiple choice questions
(b) Filling in blanks or completing a sentence
(c) Listing items, in any order or a specified order such as rank order
(d) Stating a definition
(e) Identifying a key issue, term, figure or item
(f) Calculating a specific figure
(g) Completing gaps in a set of data where the relevant numbers can be calculated from the information given
(h) Identifying points/zones/ranges/areas on graphs or diagrams, labelling graphs or filling in lines on a graph
(i) Matching items or statements
(j) Stating whether statements are true or false
(k) Writing brief (in a specified number of words) explanations
(l) Deleting incorrect items
(m) Choosing right words from a number of options
(n) Complete an equation, or define what the symbols used in an equation mean
OT questions in CIMA assessment

CIMA has offered the following guidance about OT questions in the assessment.
• Credit may be given for workings where you are asked to calculate a specific figure.
• If you exceed a specified limit on the number of words you can use in an answer, you will not be awarded
any marks.
Examples of OTs are included within each chapter, in the quick quizzes at the end of each chapter and in the
objective test question bank.
BPP Learning Media's i-Pass for this paper provides you with plenty of opportunity for further practice of OTs.
xx Introduction
International terminology
Your Fundamentals of Business Economics assessment will use international accounting terms and this text is
written in international accounting terms as defined in IAS 1.
It is a good idea to start now getting used to these terms, so the table below provides a list of UK terms with their
international equivalents.
UK term International term

Profit and loss account Income statement (statement of comprehensive income)
Profit and loss reserve (in balance sheet) Accumulated profits
Balance sheet Statement of financial position
Turnover Revenue
Debtor account Account receivable
Debtors (eg debtors have increased) Receivables
Debtor Customer
Creditor account Account payable
Creditors (eg creditors have increased) Payables
Creditor Supplier
Debtors control account Receivables control account
Creditors control account Payables control account
Stock Inventory
Fixed asset Non-current asset (generally). Tangible fixed assets are also referred to
as ‘property, plant and equipment’.
Long term liability Non-current liability
Provision (eg for depreciation) Allowance (you will sometimes see ‘provision’ used too).
Nominal ledger General ledger
VAT Sales tax
Debentures Loan notes
Preference shares/dividends Preferred shares/dividends
Cash flow statement Statement of cash flows
Introduction xxi
xxii Introduction
Part A
The goals and decisions of
organisations
2
The economic
problem
Introduction
This chapter introduces the basic economic problem, which is: how to use scarce resources
to achieve maximum benefits.
It then looks at the choices which result from this problem: what should be produced, how
should production be organised, and who should consume the output.
Finally it looks at a consequence of the economic problem: that using scarce resources for
one activity necessarily means they cannot be used for an alternative activity.
Topic list Learning outcomes Syllabus references Ability required

1 Fundamental economic ideas – – –
1 Fundamental economic ideas
FAST FORWARD Economics is concerned with how choices are made about the use of resources: what should be produced and
who should consume it. The need to make such decisions arises because economic resources are scarce. Making
decisions involves the sacrifice of benefits that could have been obtained from using resources in an alternative
course of action. This sacrifice is known as the opportunity cost of an activity.
1.1 Economics as a social science

Economics studies the ways in which society decides what to produce, how to produce it, who to produce it for
and how to apportion it. We are all economic agents, and economic activity is what we do to make a living.
Economists assume that people behave rationally at all times and always seek to improve their circumstances. This
assumption leads to more specific assumptions.
• Producers will seek to maximise their profits.
• Consumers will seek to maximise the benefits (their 'utility') from their income.
• Governments will seek to maximise the welfare of their populations.
Both the basic assumption of rationality and the more detailed assumptions may be challenged. In particular, we
will look again later at the assumption that businesses always seek to maximise their profits. A further
complication is that concepts such as utility and welfare are not only open to interpretation, but also that the
interpretation will change over time.
The way in which the choices about resource allocation are made, the way value is measured, and the forms of
ownership of economic wealth will also vary according to the type of economic system that exists in a society.
(a) In a centrally planned (or command) economy, the decisions and choices about resource allocation are
made by the government. Monetary values are attached to resources and to goods and services, but it is
the government that decides what resources should be used, how much should be paid for them, what
goods should be made and, in turn, what their price should be. This approach is based on the theory that
only the government can make fair and proper provision for all members of society.
(b) In a free market economy, the decisions and choices about resource allocation are left to market forces of
supply and demand, and the workings of the price mechanism. This approach is based on the observable
fact that it generates more wealth in total than the command approach.
(c) In a mixed economy the decisions and choices are made partly by free market forces of supply and
demand, and partly by government decisions. Economic wealth is divided between the private sector and
the public sector. This approach attempts to combine the efficiency of the market system with the centrally
planned system’s approach to fair and proper distribution.
In practice, the industrialised countries in the developed world have mixed economies, although with differing
proportions of free market and centrally planned decision-making from one country to the next. In such
economies, the government influences economic activity in a variety of ways and for a variety of purposes.
(a) Direct control over macroeconomic forces can be exercised through policy on tax, spending and interest
rates.
(b) Taxes, subsidies and direct controls can affect the relative prices of goods and services.
(c) Government-owned institutions such as the UK’s National Health Service (NHS) can provide goods and
services directly, free or at low cost at the point of consumption.
4 1: The economic problem ⏐ Part A The goals and decisions of organisations
(d) Regulation can be used to restrict or prevent the supply of goods and services.
(e) Incomes can be influenced through the tax and welfare systems.
Key terms Microeconomics is the study of individual economic units; these are called households and firms.
Macroeconomics is the study of the aggregated effects of the decisions of economic units. It looks at a complete
national economy, or the international economic system as a whole.
1.2 Scarcity of resources

It is a fact of life that the amount of resources available is limited.
(a) For the individual consumer, the scarcity of goods and services might seem obvious enough. Most people
would like to have more: perhaps a car, or more clothes, or a house of their own. Examples of services
which they would like more of include live concerts, public passenger transport and holidays.
(b) For the world as a whole, resources available to serve human consumption are limited. For example, the
supply of non-renewable energy resources such as coal and oil is, by definition, limited. The amount of
many minerals which it is feasible to extract from the earth (for example, metals of various kinds) is also
limited.
This idea of scarcity is very important in economics, because it reminds us that producers and consumers have to
make choices about what to produce or to buy.
In the case of producers, we can identify four types of resource, which are known as factors of production. Each of
these factors of production has an associated reward which accrues to its owner when it is used.
(a) Land is rewarded with rent. Although it is easy to think of land as property, the economic definition of land
is much broader than this. Land consists not only of property (the land element only: buildings are capital)
but also all the natural resources that grow on the land or that are extracted from it, such as timber and
coal.
(b) Labour is rewarded with wages (including salaries). Labour consists of both the mental and the physical
resources of human beings. Labour productivity can be improved through training, or by applying capital in
the form of machinery.
(c) Capital is rewarded with interest. It is easy to think of capital as financial resources, and the rate of interest
as the price mechanism in balancing the supply and demand for money. However, capital in an economic
sense is not 'money in the bank'. Rather, it refers to man-made items such as plant, machinery and tools
which are used to aid the production of other goods and services. As we noted above, buildings – such as
factories – are capital items.
(d) Enterprise, or entrepreneurship, is the fourth of factor of production. An entrepreneur is someone who
undertakes the task of organising the other three factors of production in a business enterprise, and in
doing so, bears the risk of the venture. The entrepreneur creates new business ventures and the reward for
the risk associated with this is profit.
Key terms Scarcity is the excess of human wants over what can actually be produced. A scarce resource is a resource for
which the quantity demanded at a nil price would exceed the available supply.
Since resources for production are scarce and there are not enough goods and services to satisfy the total
potential demand, choices must be made. Choice is only necessary because resources are scarce.
Part A The goals and decisions of organisations ⏐ 1: The economic problem 5
(a) Consumers must choose what goods and services they will buy.
(b) Producers must choose how to use their available resources, and what to produce with them.
Economics studies the nature of these choices.
(a) What will be produced?
(b) What will be consumed?
(c) And who will benefit from the consumption?
Making choices about how to use scarce resources is the fundamental problem of economics.
1.3 The production possibility curve

We can approach this central question of economics (how to allocate scarce resources) by looking first at the
possibilities of production. To take a simple example, suppose that an imaginary society can use its available
resources to produce two products, A and B. The society's resources are limited. Therefore there are restrictions
on the amounts of A and B that can be made. The possible combinations of A and B can be shown by a production
possibility curve (or frontier).
Quantity
of B
B1
B2 P
B5 Y
B4 X Production
B3 Q possibility
frontier
0 A4 A2 A5 A3 A1 Quantity of A
Figure 1 Production possibility curve
The curve from A1 round to B1 in Figure 1 shows the maximum of all the various combinations of A and B that a
society can make, given current technology, if it uses its limited resources efficiently.
(a) The society can choose to make up to:
(i) A1 units of A and none of B
(ii) B1 units of B and none of A
(iii) A2 units of A and B2 of B (point P on the curve)
(iv) A3 units of A and B3 of B (point Q on the curve)
(b) The combination of A4 units of A and B4 units of B (plotted at point X) is inside the production possibility
curve. This illustrates that more than these quantities can be made of either, or both, of A and B. Point X is
therefore an inefficient production point for the economy, and if the society were to make only A4 of A and
B4 of B, it would be using its limited resources inefficiently.
(c) Note that the production possibility curve is just what it says: it defines what is achievable if all productive
resources are fully employed. It follows that changes in the level of unemployment have no effect upon it,
because the curve represents the position where all labour resources are employed (ie there is no
unemployment).
Similarly, changes in price levels will affect the monetary value of what can be produced, but not the
volume, so they do not affect the curve either.
(d) The curve is normally drawn concave to the origin.
Question Production possibility curve
What can you say about the combination of A and B indicated by point Y in Figure 1?
Answer
Point Y lies outside the production possibility curve. Even with efficient use of resources it is impossible to
produce this combination of A and B. To reach point Y, either current resources must be increased or production
methods must be improved – perhaps by developments in technology.
The production possibility curve is an important idea in economics: it illustrates the need to make choices about
what to produce, because it is not possible to have everything.
1.4 Opportunity cost: the cost of one use for resources rather than another
Choice involves sacrifice. If there is a choice between having A and having B, and a country chooses to have A, it
will be giving up B to have A. The cost of having a certain amount of A can therefore be regarded as the sacrifice of
not being able to have the corresponding amount of B. There is a sacrifice involved in the choices of consumers
and firms (producers), as well as the choices of governments at the level of national economy.
Key terms The cost of an item measured in terms of the alternatives forgone is called its opportunity cost.
A production possibility curve illustrates opportunity costs. For example, if in Figure 1 it is decided to switch from
making A3 units of A and B3 units of B (point Q) to making A2 units of A and B2 units of B (point P), then the
opportunity cost of making (B2 – B3) more units of B would be the lost production of (A3 – A2) units of A.
The production possibility line is a concave curve and not a straight line because some resources are more useful
for making A than for making B, and vice versa. As a result, opportunity costs change as we move away from a
situation in which production is wholly devoted to either A or B. Thus, as we move away from point A1, and
introduce an increasing level of production of B, the amount of B that we gain from losing each unit of A
progressively diminishes.
At the level of the firm, the production possibility curve can be seen as showing the maximum output of different
goods a firm can produce when all of its resources are fully used. For example, a firm might operate production
lines capable of producing washing machines or refrigerators; producing more washing machines bears the
opportunity cost of a lower level of production of refrigerators.
Part A The goals and decisions of organisations ⏐ 1: The economic problem 7
Chapter roundup
• Economics is concerned with how choices are made about the use of resources: what should be produced and
who should consume it. The need to make such decisions arises because economic resources are scarce. Making
decisions involves the sacrifice of benefits that could have been obtained from using resources in an alternative
course of action. This sacrifice is known as the opportunity cost of an activity.
Quick quiz
1 What is the essential feature of a command economy?
2 Macroeconomics is the study of economic units such as households and firms. True or false?
3 Which of the following is not recognised as a factor of production?
A Capital
B Management
C Land
D Labour
4 The cost of an item measured in terms of the resources used is called its opportunity cost. True or false?
Answers to quick quiz

1 Decisions about resources, production and prices are made by the government.
2 False. The study of individual economic units is called microeconomics. Macroeconomics is the study of a
complete national economy.
3 B The fourth factor is enterprise or entrepreneurship.
4 False. Opportunity cost is defined as the cost of an item in terms of the alternatives forgone. Cost in terms of
resources used is a reasonable definition of the accounting concept of ‘full cost’.
Now try the questions below from the Exam Question Bank
Question numbers Page

1–2 425
Economic systems
and organisations
Introduction
Most major industrialised countries have mixed economies, with both a large private sector
and also a substantial public (or government) sector.
In this chapter we will look more carefully at the kinds of organisations that undertake
economic activity, their objectives, and some ideas about the way in which they should be
run. As part of this we will look at the issue of corporate governance.
We conclude the chapter with a discussion of the role of shareholders, and a look at some of
the methods used to compute their interest in the firms they invest in.
Topic list Learning outcomes Syllabus references Ability requ ired

1 Organisations A (i) A (1), A (6) Comprehension
2 The objectives of firms A (i), A (vii) A (1) Comprehension
3 Corporate governance A (vi), A (viii) A (7), A (8) Comprehension
4 Shareholders’ interest A (v) A (1) Comprehension
5 Measuring sh areholder wealth A (v) A (4), A (5) Comprehension
1 Organisations
FAST FORWARD Various types of organisation are found in the mixed economy. The economy can be divided into the public and
private sectors. The public sector contains a range of organisations that provide public services and may also
include some state-owned businesses. The private sector includes both profit-seeking businesses and non-profit-
making organisations such as charities, and mutuals.
1.1 The public and private sectors

The economy of a developed country can usually be divided into two sectors: the public sector and the private
sector. Private sector organisations, also called businesses, are owned and operated by private individuals or
institutions, while organisations in the public sector are owned by the state.
1.2 Private sector organisations

There are two main types of private sector organisations: those that seek profit for their owners, and those that
have other objectives. The latter are known as non-profit making or not-for-profit organisations. However, the
majority of organisations in the private sector are businesses which aim to make profits for their owners
(shareholders).
1.2.1 Non-profit organisations

This terminology is a little misleading, in that ‘non-profit' organisations often engage in profitable trade and they
are not able to run consistently at a loss. The essence of their status as ‘non-profit' organisations is not that they
seek to avoid generating a surplus of funds, but that the generation of wealth for their owners is not the primary
purpose of their existence. Not-for-profit organisations still aim to operate as efficiently as possible, but their
primary objective is to provide a service rather than to maximise profit. Non-profit seeking organisations include
co-operatives and mutual organisations; charities; and unincorporated clubs, societies and associations.
Non-profit making organisations use the surplus they generate to further their other objectives. Clubs and
associations exist to provide some kind of benefit to their members. Charities and voluntary organisations
generally exist to provide some kind of benefit to society at large, although UK law allows the potential
beneficiaries of a charity to be restricted to a defined group, such as the victims of a particular disaster.
Mutual organisations are a special case in the private sector. The essence of their nature is that they are
commercial operations owned by their customers rather than having shareholders for whom they have to earn
profit. This means that their customers benefit both from the services the mutuals provide to them and from the
trading surplus they make by doing so. It is also possible for the managers of mutuals to pursue purposes other
than profit. These can include a high level of charitable giving, the promotion of community interests, and a high
quality of service; such pursuits may well provide a high degree of intangible benefit to members. Mutuals thus
resemble both non-profit making organisations and profit-seeking companies.
Although non-profit organisations are not profit seekers, they still use economic factors of production to produce
goods or services. Therefore they need to be efficiently managed so that their resources are used effectively to
meet the objectives of the organisation whilst not making a financial loss.
The reference to effectiveness is very important here. Being cost effective is one of the key economic aims of non-
profit organisations.
10 2: Economic systems and organisations ⏐ Part A The goals and decisions of organisations
1.2.2 Profit seeking organisations
The economy is mostly driven by the profit-seeking part of the private sector. It is profit-seeking businesses that
undertake the most enterprising aspects of economic activity; provide the bulk of employment opportunities and
tax revenue; and create the growth needed to enhance economic welfare. Remember also the point we made in
Chapter 1: that economists assume that producers will seek to maximise their profits.
Businesses are of two main types, distinguished by the extent to which the owners are liable for the debts of the
undertaking.
(a) An individual may set up business on his or her own account, as a sole trader or in partnership with
others. In either case, the law will not distinguish between the private assets and liabilities of the owners
and those of the enterprise. The owners have unlimited liability for the debts of their businesses.
(b) This degree of risk is unattractive to many potential investors, so to enable them to invest and thus release
more funds for wealth-producing enterprise, the legal systems of most countries provide for some form of
limited liability enterprise. Such businesses are referred to as corporations or companies.
In the UK, there are two forms of limited liability company. They both limit the liability of investors to the nominal
value of their share holdings; however, they differ in the extent to which they are permitted to solicit investment
from the general public. Private limited companies may not offer their securities to the public; a public limited
company (plc) may. When the shares of plcs are regularly bought and sold on a stock exchange, they may be
referred to as quoted companies, because the current price of their shares will be quoted in a journal of record.
Assessment Remember that not all public limited companies are quoted companies.
focus point
Note carefully the confusing terminology here: public limited companies are owned by private investors
(shareholders); they are not part of the public sector.
1.3 Public sector organisations

We used to divide public sector organisations into two main groups: those that provide public services, such as
hospitals, schools, the police and the armed forces; and state owned industries. This distinction has become less
clear at the end of the 20th century and moving into the 21st century, as governments have privatised state-owned
industries and sought to reform the public sector by involving private companies in the provision of public
services. The objective has been to curb waste of public money and improve efficiency by importing the
disciplined cost control that is required if profit is to be created.
In the UK, many providers of public services, such as hospitals and schools, and formerly state owned industries,
such as London Underground, are now involved in different forms of public-private partnership. In such
partnerships, the private sector provides funds for public sector purposes such as education. For example the
Private Funding Initiative (PFI) for schools seeks private partners to fund and manage school buildings in return for
an agreed fee. Some services in the UK such as the National Health Service (NHS) are provided by self-governing
trusts. These trusts sell their services to the NHS.
Public sector bodies are all, ultimately, responsible to government for their activities, and their purposes are
defined in the laws that establish them. They have a range of possible aims and objectives: rarely will they set out
to trade at a profit. Nevertheless, their managers will be expected to exercise good stewardship and prevent waste
of resources. Public sector bodies' objectives will usually be defined in terms of the provision of a service that is
deemed to be beneficial to society.
It is an important feature of public sector bodies that (unless they engage in trade of some kind) they have little
control over their incomes; they depend upon government for the funds they need to operate. The funds they
receive will be influenced by a large number of forces, including current public opinion, government aspirations,
Part A The goals and decisions of organisations ⏐ 2: Economic systems and organisations 11
the skill of their leaders in negotiation, the current state of the public finances overall and the current economic
climate.
Alongside public sector organisations there are also quasi autonomous non-governmental organisations
(QUANGOs), which are private organisations independent of the government but to which governments have
devolved the authority for running public services.
Examples in the UK include the Environment Agency, Regional Development Agencies, and regulators such as
Ofcom.
1.4 Primary, secondary and tertiary sectors

A distinction can be made between the primary, secondary and tertiary sectors of the economy.
1.4.1 The primary sector

The primary sector of the economy produces raw materials such as crops and minerals. Agriculture, forestry,
fisheries, mining and quarrying are the main industries in this sector. Over the long term, the trend for the primary
sector in developed countries such as the UK is one of decline when measured in terms of its share of gross
domestic product (GDP). Viewed against the process of economic growth, this declining share reflects the rising
absolute level of output of other industries.
1.4.2 The secondary sector

The secondary sector consists of industries that process raw materials in order to manufacture goods. This
sector is therefore also known as the manufacturing sector. Manufacturing in the UK is in a state of decline, mainly
because of competition from developing, low-wage countries which can manufacture finished goods more cheaply
than the UK can.
1.4.3 The tertiary sector

The tertiary sector provides services and is therefore also known as the service sector. This sector has become
the predominant provider of employment and output in the UK economy in recent decades. A major reason for the
continuing growth in this sector has been the expansion in the banking, finance and insurance sectors. However,
the onset of recession in 2008 saw a number of jobs being cut in these sectors.
2 The objectives of firms

FAST FORWARD
Although it is convenient for economists to assume that profit maximisation is the central objective of firms, we
should not overlook the fact that in reality the motives of managers may operate to serve alternative goals.
2.1 The firm

Key terms Firm is the term used in economics for any organisation that carries on a business.
We will use the rest of this Chapter to examine firms, and the way they are managed and controlled.
2.2 Profit maximisation and other objectives
Profit maximisation is usually assumed to be the goal of the firm. However, this assumption pre-supposes both
that the owners of the firm are in control of the everyday management of it, and also that the owners want to
achieve the highest profits that they can.
If these two premises are not met, then the logic behind the assumption of the profit maximising firm is flawed.
The profit maximising assumption is not universally accepted: the great management thinker Peter Drucker said
that a business exists ‘to create a customer', by which he meant that its activities were best explained in terms of
marketing activity. Other writers have suggested that survival is the main long-term aim. We discuss some other
ideas later in this section.
Where the entrepreneur is in full managerial control of the firm, as in the case of a small owner-managed company
or partnership, the profit maximisation assumption would seem to be very reasonable. However, some companies
have considerations that constrain their ability to maximise profits. These include the demands of ethics in
pharmaceutical and medical companies, the requirement to provide a public service where specific subsidies are
received, and the demands of safety in shipping and airline companies. The process of incorporating UK
companies may define its particular type of business, though it is possible to incorporate as a ‘general commercial
company', which makes it legal for the company to undertake any kind of legal business activity.
2.3 Agency theory and the principal-agent problem

FAST FORWARD
Where the management of a business is separated from its ownership by the employment of professional
managers, the managers may be considered to be the agents of the owners. Agency theory is concerned to
analyse the way agents may be expected to behave and how they can be motivated to promote their principals'
interest.
In fact, few large businesses are managed by their owners. In the case of larger companies, there are large
numbers of shareholders, and they are unlikely to wish to take part in the management of the company, viewing it
simply as a vehicle for investment. Even where ownership is concentrated, large companies tend to be managed
mostly by professional managers who have little ownership interest, if any. This separation of ownership from
control has arisen for several reasons.
(a) Limited liability structure does not give shareholders power to manage the company (unless they are also
managers); their influence normally extends only to proposing and voting on resolutions at company
meetings.
(b) It is impracticable for a large number of shareholders to exercise managerial powers jointly; to be effective,
power must be concentrated.
(c) Many shareholders are not interested in being managers, and are content to employ professional managers,
so long as their investment prospers.
(d) Many organisations are so large or complex, or deal with such advanced technology, that they can only be
managed effectively by well-qualified professionals.
Separation of ownership from control has been a feature of business for over a century and brings with it a
recurring problem: the business should be managed so as to promote the economic interest of the shareholders as
a body, but the power to manage lies in the hands of people who may use it to promote their own interests. How
can the managers be made to favour the interest of the owners rather than their own?
This problem is not confined to the management of companies: it is the general problem of the agency
relationship and occurs whenever one person (the principal) gives another (the agent) power to deal with his
affairs. This separation of ownership from control is known as a principal-agent problem.
2.3.1 Resolving the agency problem

A common approach to ensuring that company managers act in the owners' interest is to offer them reward
incentives that depend on the achievement of ownership goals. Thus, it is common for Chief Executives'
remuneration to depend, at least in part, on satisfactory achievement in such matters as profit and share price. At
lower levels, bonus schemes can be based on achieving targets that support good overall performance, such as
improved sales or reduced costs. Profit sharing schemes that provide shares to large numbers of employees are
intended to align employees' interests with those of the wider body of shareholders.
Unfortunately, these types of approach can be flawed in that they have to be designed – and the designers
themselves are in an agency relationship with the owners, such that their objectives may conflict with the owners'
(shareholders') objective of profitability. Thus executive remuneration schemes have been criticised for
emphasising the wrong targets or for setting the targets too low.
2.4 Alternative managerial goals

Under the conditions of the agency relationship between owners and managers, the goal of profit maximisation
might not fully explain management behaviour, because managers have interests of their own.
Managers will not necessarily make decisions that will maximise profits.
(a) They may have no personal interests at stake in the size of profits earned, except in so far as they are
accountable to shareholders for the profits they make.
(b) There may be a lack of competitive pressure in the market to be efficient, minimise costs and maximise
profits, for example where there are few firms in the market.
It has been suggested that price and output decisions will be taken by managers with managerial objectives in
mind. Rather than seeking to maximise profits, managers may choose to achieve a satisfactory profit for a firm:
this is called satisficing. Satisficing is also a common managerial response when there are multiple objectives,
such as boosting share price, and achieving revenue growth. Similarly, if directors' remuneration schemes are
based on criteria such as growth or corporate social responsibility, then they are unlikely to make the maximisation
of profit their sole objective.
2.5 Baumol's sales maximisation model

One managerial model of the firm – Baumol's sales maximisation model – assumes that the firm acts to
maximise sales revenue rather than profits. The management of a firm might opt for sales revenue maximisation
in order to maintain or increase its market share, ensure survival, and discourage competition. Managers benefit
personally because of the prestige of running a large and successful company, and also because salaries and other
perks are likely to be higher in bigger companies than in smaller ones.
2.6 Williamson's management discretion model

Another managerial model – Williamson's management discretion model – assumes that managers act to further
their own interests and so maximise their own utility (or satisfaction), subject to a minimum profit requirement.
Utility may be thought of in terms of prestige, influence and other personal satisfactions. The profit aimed for will
not be maximum profit, because of management's wish for expenditure on themselves and their staff, and the
privileges of management.
2.7 A behavioural theory of the firm
Cyert and March suggested that a firm is an organisational coalition of shareholders, managers, employees and
customers, with each group having different goals, so there is a need for political compromise in establishing the
goals of the firm. Each group must settle for less than it would ideally want to have. Shareholders must settle for
less than maximum profits; managers for less than maximum utility; and so on.
Despite the range of these theories, the ultimate goal of many managers is simply survival.
3 Corporate governance
Key term Corporate governance is the systems by which companies and other organisations are directed and controlled.
CIMA Official Terminology
3.1 Management accountability

FAST FORWARD
Organisations are not autonomous; they are governed and controlled to serve some external purpose. All managers
have a duty of faithful service to the external purpose of the organisation.
As the agents of its owners, a company's managers are collectively responsible for the conduct of its affairs. This
is true of organisations generally, whatever their nature and whether or not they seek profit. There is a chain of
authority and accountability that runs hierarchically up and down the organisation. Junior managers are
accountable to more senior ones and so on up the chain until the most senior managers are reached. The question
then arises: who are these senior managers accountable to for the activities of the organisation as a whole? As a
matter of principle, we can say that there should be some external entity on behalf of which the most senior
managers control the organisation and to which they are accountable.
Question Accountability
Who are the senior managers of the following organisations and to whom are they accountable?
(a) A charity
(b) The government of a democracy
(c) A trade union
Answer
(a) The senior management of a charity is likely to be similar in nature to the board of a company, consisting of
heads of departments (such as fundraising and operations) together with some non-executive directors.
Their collective responsibility is likely to be to subscription-paying members of the institution assembled in
a general meeting, where these exist, or possibly to a supervisory board, or even to a court of law. In any
event, the actions of the managers in dealing with the interests of those the charity is intended to benefit
will be the main concern.
(b) The senior management of a democratic government is called the Cabinet and, again, consists of senior
politicians with functional and advisory roles. The external body to which it is responsible is the electorate
(the members of the public), who have the power collectively to expel the government from office and
install a completely different one.
(c) The senior management of a trade union will consist of senior executives and, depending on its
constitution, is likely to be responsible to the membership of the union. The extent of this responsibility will
depend on local law and tradition and may be discharged for example, through postal ballots or, less
satisfactorily, through mass meetings.
In a company, although the shareholders own the company, the responsibility for directing and controlling the
company rests largely with the board of directors. The respective power and key responsibilities of shareholders
and directors are summarised in the table below.
Shareholders Board of directors

Appoint the directors Determine the strategy of the company
Oversee the management of the company and its performance in achieving
strategy and objectives
Report to shareholders on the performance of the company
Appoint the auditors
Assure themselves that the system Ensure suitable internal controls are in place and the company complies
of corporate governance is with laws and regulations.
appropriate and effective
3.2 Fiduciary responsibility

The essence of all these examples of external accountability is that organisations are not autonomous: that is to
say, they do not exist to serve their own purposes or those of their senior managers. They exist to serve some
external purpose and their managers have a duty to run them in a way that serves that purpose, whether it be to
relieve distress (a charity), to keep the peace and manage the economy (a government), to promote the interests of
its members (a trade union), or to make a profit (a business). Managers have a fiduciary responsibility (or duty of
faithful service) in this respect and their behaviour must always reflect it.
3.3 The objectives of commercial organisations

We implied earlier that the objective of a commercial organisation is to make a profit. It is possible to argue that
wider objectives should be acknowledged, and that the interests of people other than the owners should also be
served. This is the ‘stakeholder view' and is discussed further below. Nevertheless, whatever an organisation's
objectives may be, it is the duty of its managers to seek to attain them. Many senior figures in the world of
business have given the impression that the organisations they run exist to serve their own personal purposes.
This is not the case and managers at all levels must be aware of this.
3.4 Personal motivation and corruption

We shall have something more to say about corrupt practices later on in this chapter, but for now, we must
emphasise that managers need not be actually corrupt in order to fail in their fiduciary duty. The CEO who sets in
motion a takeover bid that will enhance his prestige; the head of department who ‘empire builds'; and the IT
manager who buys an unnecessarily sophisticated enterprise resource management system are all failing in their
fiduciary duty even though they receive no material benefit themselves.
3.5 Stakeholders
FAST FORWARD
The stakeholder view holds that there are many groups in society with an interest in the organisation's activities.
Stakeholders can be divided into internal, connected and external groups. The organisation's response to their
priorities can be analysed according to their power (or influence) and their interest.
Stakeholders are persons or groups that have a legitimate interest in a business's conduct and whose concerns
should be addressed as a matter of principle. Many stakeholder groups have influence over they way in which
organisations are managed and operate. They can therefore be fundamental to corporate governance.
Key terms Stakeholders are those persons and organisations that have an interest in the strategy and behaviour of an
organisation. CIMA Official Terminology
There are three broad types of stakeholder in an organisation.

• Internal stakeholders such as employees and management
• Connected stakeholders such as shareholders, customers, suppliers and financiers
• External stakeholders such as the community, government and pressure groups
Stakeholders:
Banks and
Connected Shareholders Customers Suppliers
financiers
INTERNAL
Internal eg Management
Employees
External Pressure
Community Government
groups
The extent to which external stakeholders are recognised is linked to the size of the organisation, in that the
policies and actions of larger organisations are more likely to be of interest to national governments and even
international bodies than are those of smaller organisations.
Stakeholders may also be analysed into those who have a formal contractual relationship with the organisation and
those who do not. These two groups are called primary and secondary stakeholders. Internal and connected
stakeholders fall into the primary category, therefore, while external stakeholders equate to secondary
stakeholders.
Mendelow classified stakeholders on a matrix whose axes are power (or influence) the stakeholder can exert and
degree of interest the stakeholder has in the organisation's activities. These factors will help define the type of
relationship the organisation should seek with its stakeholders.
Level of interest
Low High
Low A B
Power/influence
High C D
(a) Key players are found in segment D: any strategy the organisation wants to adopt must be acceptable to
them, at least. An example would be a major customer. Key stakeholders may participate in decision-
making.
(b) Stakeholders in segment C must be treated with care. While often passive, they are capable of moving to
segment D. They should, therefore be kept satisfied. Large institutional shareholders might fall into
segment C.
(c) Stakeholders in segment B do not have great ability to influence strategy, but their views can be important
in influencing more powerful stakeholders, perhaps by lobbying. They should therefore be kept informed.
Community representatives and charities might fall into segment B.
(d) Minimal effort is expended on segment A. An example might be a contractor's labour force.
Internal stakeholder groups are likely to have both more influence and more interest than external groups.
Coalitions of stakeholder groups are likely to have more influence than single stakeholders or small uniform
groups.
3.6 Stakeholder influence

Stakeholders are particularly important to understanding the policies and actions of non-profit organisations.
Such bodies do not have an over-riding responsibility to promote the interests of the owners: instead, they are
subject to significant influence from more than one stakeholder group. The concept of the behavioural coalition is
particularly relevant here, since there is often a clear need for the organisation's managers both to recognise and to
manage the expectations of the various stakeholder groups. Groups of stakeholders with a common interest
(coalitions) will have more influence than a single stakeholder.
A charity is a good example. There will be a class of beneficiaries whose requirements are the reason the
organisation exists. However, there are also likely to be at least two other important stakeholder groups whose
views and requirements must be carefully considered.
(a) Donors are likely to be very interested in the way the funds they have supplied are used. The charity will
hope the donors will continue to provide funds in the future, and so the charity will be keen to demonstrate
that funds have been put to good use.
(b) Employees, particularly those working directly with beneficiaries, are likely to be highly motivated and to
have high ideals about the role of the charity. They may accept low rates of pay because they feel that their
work is important to society.
These two stakeholder groups are likely to be very vocal if disappointed. They are fundamental to operations and
are able to disrupt them if they wish to, simply by walking away. It is important that they are not disappointed or
aggrieved.
In general, we may discern three areas in which stakeholders exercise influence in non-profit organisations.
(a) Objectives and goals are not based on profit, so there is scope for stakeholders to influence what the
organisation sets out to do.
(b) Strategies cannot be aimed simply at profitability, so it can be developed to achieve other ends, such as
effectiveness and economy. Many non-profit organisations will demand a particularly high standard of
conduct in ethical terms.
(c) Management style and practices, particularly those elements that relate to the management of people, are
highly likely to be of interest to some stakeholder groups.
3.7 Stakeholder conflicts

Since their interests may be widely different, conflict between stakeholders can be quite common. Managers must
take the potential for such conflict into account when setting policy and be prepared to deal with it if it arises in a
form that affects the organisation.
Hunt identifies five different initial management responses to the handling of conflict.
(a) Denial/withdrawal. Torrington and Hall say that 'to some extent conflict can be handled by ignoring it.' If
the conflict is very trivial, it may indeed 'blow over' without an issue being made of it, but if the causes are
not identified, the conflict may grow to unmanageable proportions.
(b) Suppression/accommodation. One party suppresses its own interest and accommodates the other in order
to preserve working relationships despite minor conflicts. As Hunt remarks, however: 'Some cracks cannot
be papered over'.
(c) Dominance: the dominant group (dominant coalition) may be able to apply power or influence to settle the
conflict. The disadvantage of this is that it creates all the lingering resentment and hostility of 'win-lose'
situations.
(d) Compromise: a consensus may be reached by bargaining and negotiating. However, individuals tend to
exaggerate their positions to allow for compromise, and compromise itself is seen to weaken the value of
the decision, perhaps reducing commitment.
(e) Integration and collaboration: it may be most appropriate to confront the issue on which the parties differ
and work towards an accommodation of the differences. This may lead to a better overall solution than
simply splitting the difference. Emphasis must be put on the task, individuals must accept the need to
modify their views for the sake of the task at hand, and group effort must be seen to be superior to
individual effort.
3.8 Failures of corporate governance

FAST FORWARD
A number of reports have been produced in various countries aiming to address the risk and problems posed by
poor corporate governance.
There were three significant corporate governance reports in the United Kingdom during the 1990s. The Cadbury
and Hampel reports covered general corporate governance issues, whilst the Greenbury report concentrated on
remuneration of directors.
The recommendations of these three reports were merged into a Combined Code in 1998, with subsequent
updates, with which companies listed on the London Stock Exchange are required to comply.
Though mostly discussed in relation to large quoted companies, governance is an issue for all bodies corporate;
commercial and not for profit.
An increasing number of high profile corporate scandals and collapses at the start of the 1990s, including Polly
Peck International, BCCI, and Maxwell Communications Corporation prompted the development of governance
codes in the 1990s. However, scandals since then, such as Parmalat and Enron, have raised questions about
further measures that may be necessary. These high profile cases have highlighted the need for guidance to tackle
the various risks and problems that can arise in organisations' systems of governance.
3.8.1 Domination by a single individual

A feature of many corporate governance scandals has been boards dominated by a single senior executive doing
what that executive wants with other board members merely acting as a rubber stamp. Sometimes the single
individual may even bypass the board to action his own interests. The report on the UK Guinness case suggested
that the Chief Executive, Ernest Saunders paid himself a $3 million reward without consulting the other directors.
The presence of non-executive directors on the board is felt to be an important safeguard against domination by a
single individual.
3.8.2 Lack of involvement of board

Boards that meet irregularly or fail to consider systematically the organisation's activities and risks are clearly
weak. Sometimes the failure to carry out proper oversight is due to a lack of information being provided.
3.8.3 Lack of adequate control function

An obvious weakness is a lack of internal audit, since this is one of the most important aspects of internal control.
Another important control is lack of adequate technical knowledge in key roles, for example in the audit
committee or in senior compliance positions. A rapid turnover of staff involved in accounting or control may
suggest inadequate resourcing, and will make control more difficult because of lack of continuity.
3.8.4 Lack of supervision

Employees who are not properly supervised can create large losses for the organisation through their own
incompetence, negligence or fraudulent activity. The behaviour of Nick Leeson, the employee who caused the
collapse of Barings bank, was not challenged because he appeared to be successful, whereas he was using
unauthorised accounts to cover up his large trading losses. Leeson was able to do this because he was in charge
of both dealing and settlement, a systems weakness or lack of segregation of key roles that featured in other
financial frauds.
3.8.5 Lack of independent scrutiny

External auditors may not carry out the necessary questioning of senior management because of fears of losing the
audit, and internal audit do not ask awkward questions because the chief financial officer determines their
employment prospects. Often corporate collapses are followed by criticisms of external auditors. Famously,
following the collapse of Enron in 2001, Arthur Andersen's audit work was investigated in connection with
allegations that Andersen had ignored high-risk accounting issues.
3.8.6 Lack of contact with shareholders

Often board members may have grown up with the company but lose touch with the interests and views of
shareholders. One possible symptom of this is the payment of remuneration packages that do not appear to be
warranted by results. Equally, the directors may choose to pursue their own interests and ignore the requirements
of the shareholders.
3.8.7 Emphasis on short-term profitability
Emphasis on short-term results can lead to the concealment of problems or errors, or manipulation of accounts
to achieve desired results.
3.8.8 Misleading accounts and information

Often misleading figures are symptomatic of other problems (or are designed to conceal other problems) but in
many cases, poor quality accounting information is a major problem if markets are trying to make a fair
assessment of the company's value. Giving out misleading information was a major issue in the UK's Equitable Life
scandal where the company gave contradictory information to savers, independent advisers, media and regulators.
3.9 Benefits of improving corporate governance

3.9.1 Risk reduction
Clearly, the ultimate risk is of the organisation making such large losses that bankruptcy becomes inevitable. The
organisation may also be closed down as a result of serious regulatory breaches, for example misapplying
investors' monies. Proper corporate governance reduces such risks by aligning directors' interests with the
company's strategic objectives, and by providing for measures to reduce fraud.
3.9.2 Performance
Performance should improve if accountabilities are made clear and directors' motivation is enhanced by
performance-related remuneration. Also, the extra breadth of experience brought by non-executive directors, and
measures to prevent domination by a single powerful figure, should improve the quality of decision-making at
board level.
3.9.3 External support

External perceptions of the company should be enhanced through having a robust system of corporate
governance. This can have wide-ranging benefits.
• Improved ability to raise finance
• Improved corporate image with public and government
• Improved relations with stakeholders such as customers and employees
3.10 Reports on corporate governance

There have been a number of important reports on corporate governance, in the UK and elsewhere. These have
dealt primarily with companies, but many of the principles are equally applicable to non-profit organisations.
3.10.1 Cadbury report (1991)

The Cadbury Committee created a Code of Best Practice for corporate governance in the UK, based on openness,
integrity and accountability. Their recommendations also included requirements for regular meetings of the board
of directors, and the greater involvement of non-executive directors to bring impartiality and independence to the
board. (Non-executive directors have no financial interests in the company of which they are directors.) In order to
promote openness and transparency, the Cadbury report recommended that all directors' rewards and
remuneration should be publicly disclosed.
3.10.2 Greenbury report (1995)
The Greenbury Committee considered the problem of rewarding performance in an appropriate fashion and made
recommendations to improve accountability, transparency and the improvement of performance and directors'
pay.
3.10.3 The Hampel report (1998)

The major recommendations of the committee were that shareholders should be able to vote separately on each
substantially separate issue; and that the practice of 'bundling' unrelated proposals in a single resolution should
cease.
3.10.4 The Higgs Report (2003)

The Higgs Committee Report ('Review of the role and effectiveness of non-executive directors') reviewed issues
surrounding the composition of boards of directors, including the age, gender, skills and abilities of the members
of a Board. Higgs recommended that at least half the members of a Board, excluding the chairman, should be
independent non-executive directors. Higgs also recommended that a description of how the Board operates
should be included in a company's Annual Report.
3.10.5 Stock Exchange Combined Code

The recommendations of the various reports have been consolidated into the Stock Exchange Combined Code,
which sets out standards of best practice in relation to issues such as board composition, remuneration and
accountability.
The board
Every director should use independent judgement when making decisions. Every director should receive
appropriate training.
There should be an appropriate balance between executive and non-executive directors. This means there should
be a strong and independent body of non-executive directors with a recognised senior member other than the
chairman.
Nominations committee
There are should be a nominations committee to oversee appointments to the board.
Chairman and Chief Executive
There are two leading management roles; running the board (chairman) and running the company (chief
executive). A clear division of responsibilities should exist so that there is a balance of power, and no-one person
has unfettered powers of decision. Combination of the roles of chairman and chief executive should be justified
publicly.
Remuneration
Companies should establish a formal and clear procedure for developing policy on executive remuneration and for
fixing the remuneration package of individual directors. Directors should not be involved in setting their own
remuneration. A remuneration committee, staffed by independent non-executive directors, should make
recommendations about the framework of executive remuneration, and should determine specific remuneration
packages. The board should determine the remuneration of non-executive directors
Audit committees and auditors
There should be formal and clear arrangements with the company's auditors, and for applying the financial
reporting and internal control principles. Companies should have an audit committee consisting of non-executive
directors, the majority of whom should be independent. The audit committee should review the audit, and the
independence and objectivity of the auditors. In particular the committee should keep matters under review if the
auditors supply significant non-audit services.
4 Shareholders' interest
FAST FORWARD
Investors invest in companies by buying their shares. The companies are expected to maximise the wealth of their
shareholders by generating profit from trading operations. Investors will only provide funds if they believe that the
prospective returns are adequate.
4.1 Shares and share prices

A company is one of the commonest vehicles for carrying out a business. Funds are raised for the business
activity by dividing up the ownership of the company into equal parts called shares that are then sold to investors
for cash. The shares are ordinary shares if they have no additional rights attached to them such as priority rights
to receive payments from the company. The company uses the money it receives from issuing shares, together
with bank loans and retained profits, to finance its activities.
A shareholder is someone who owns shares in a company. The number of shares held by a shareholder
represents his proportional ownership of the profits, losses and assets of the company. Any ownership interest is
generally known as equity. Thus, if your house is worth more than your outstanding mortgage, the difference is
your equity in the property. Ownership of shares represents ownership of equity in the company concerned: the
term ‘equities' is often used to mean shares in companies. This is by contrast with bonds, which represent a
formal loan to the company, rather than an ownership interest.
Preference shares are a special class of shares that you will learn more about later in your accounting studies. For
now, we may simply say that not all companies have them and we will not include them in the category of equity
shares.
We discussed the objectives of companies earlier in this chapter. We will work on the basis that the main financial
objective of a company is to maximise the wealth of its shareholders. It does this by trading at a profit. Profits
can then be paid to the shareholders as dividends, which are an immediate cash benefit, or they can be retained
and re-invested in the company, which should increase the value of the shareholders' equity, generating wealth
for the shareholder in the longer term.
Shares in quoted companies are usually bought and sold via an official stock exchange market, such as the
London Stock Exchange. Buying and selling prices for each share are quoted by the exchange's dealers. If a
company's shares are traded on a stock market, the wealth of the shareholder is increased when the share price
goes up.
The ordinary shares of UK companies have a nominal value, typically £1, 50p or 10p. Outside the UK it is not
uncommon for a company's shares to have no nominal value. The market value of a quoted company's shares
bears no relation to their nominal value, except when the company issues new ordinary shares for cash: then the
issue price must be at least equal to the nominal value of the shares.
4.2 Return on investment
Money is required for all forms of business activity and, of course, it is not freely available. If you wish to borrow
money to buy a car, the finance company will expect you to pay interest. A similar principle applies when
companies raise funds by issuing shares: the investors expect to see a return on their investment. Shareholders
are assumed to have a firm idea of the return they require from their investments: this will be based in part on the
performance of other similar investments. Generally, the source of this return will be the company's profits. As
already mentioned, these can either be used to fund the payment of dividends or they can be retained and
reinvested in the business. In either case, the shareholders' wealth increases.
Income, in the form of profit, and capital, in the form of the market value of equities, are very much equivalent
when considering a quoted company, because cash and shares are easily converted into one another by
appropriate dealings on the relevant stock exchange. Also, any increase in value would be easily apparent in the
case of a quoted company, since the market value of its shares would be public knowledge. It is far less obvious
(and possibly difficult to establish and measure) in the case of a private company, since the shares of private
companies are not actively traded. Therefore, most of what we will have to say in the rest of this Chapter will relate
to quoted companies and their shareholders.
Two very important considerations when deciding whether to buy shares in a company are its current share price
and its prospects for the future. Investors will ask themselves whether they can reasonably expect to receive a
proper return on their investment, either in dividends or in the form of an increase in the value of their shares.
This will be generally true whether they are taking up an initial issue of shares or buying existing shares on a stock
exchange.
A further important consideration in deciding just what would be a proper return is the risk associated with the
investment. A high degree of risk means that returns are likely to accrue at irregular intervals and that they are
likely to be variable in amount. Therefore, the higher the risk, the higher the overall return the shareholder will
require. This is an important principle that you will return to later in your CIMA studies.
The market price of a firm's shares is thus subject to a number of influences connected with the investment's likely
effect on shareholder wealth. Good profit performance will tend to push the price up, as will enhanced prospects
for the future, such as better trading conditions. An increase in risk will tend to push the share price down, as will
reduced prospects for future profit. These influences on share price themselves result from the interplay of a large
number of factors; these factors can be divided into those internal to the firm and those external to it.
(a) Internal factors are heavily influenced by management policy and action and include such things as rate of
new product development, marketing activity, financial management and control of costs.
(b) External factors include wider developments such as economic recession and demographic change; and
events and forces specific to the industry concerned, such as the degree of competition in the market and
the behaviour of suppliers and customers.
The senior managers of a quoted company are under pressure to maintain and, if possible, improve current profit
performance, while, at the same time, continuing to invest for the future. Shareholders are assumed to monitor
the performance of the companies they invest in and are likely to sell their shares in companies that under-
perform in order to invest in companies that seem to be performing more satisfactorily. If a large number of
shareholders decide to dispose of their shares, the market forces of supply and demand (which are dealt with later
in this Study Text) will cause the share price to fall to a level that reflects its performance and prospects.
Conversely, the same forces will tend to drive up the price of shares in a company that is seen to be
outperforming its rivals.
5 Measuring shareholder wealth
FAST FORWARD
Shareholders need objective measures of company performance if they are to make sensible investment
decisions. Short-term measures include ROCE, EPS and P/E figures. ROCE and EPS are straightforward measures
of current achievement; P/E number, however, reflects the market's view of the share's future prospects.
Shareholders need some objective measures of company performance so that they can make informed investment
decisions. These measures can be divided into those suitable for the shorter term and those suitable for the longer
term. In this context, the limit of the shorter term may be taken to be the issue of the next set of financial
statements.
5.1 Short-term measures

5.1.1 Return on capital employed
Return on capital employed (ROCE) is a measure of a company's current success in using the money invested in
it to generate a return. The amount of profit is not in itself an adequate measure: it must be related to the value of
the resources employed in generating it, so that it reflects the efficiency with which they have been used. ROCE
does this for us.
In the simplest terms, ROCE is calculated as profit divided by capital employed: for most companies, this will
produce an answer that can be expressed as a percentage between zero and, say, 50%. Clearly if the company
makes a loss, the ROCE figure will be negative; ROCE figures above 50% are not impossible, but would be
considered unusual (and possibly too good to be true). A very high return might well indicate a rather speculative
and therefore risky investment.
We would hope that a company's ROCE would be higher than the minimum level its shareholders have decided is
acceptable to them as a return on their investment. The greater the margin of safety between this required return
and ROCE, the better.
Unfortunately both profit and capital employed are accounting concepts and can be defined in a number of
different ways. The principle employed here is that ROCE is of interest to all parties with a claim on the company's
profits, including both shareholders and lenders, so it is best to compute both capital and profit in terms that
relate to all categories of providers of capital. As result, the figure for profit is most usually taken before the
payment of tax and interest to lenders, while capital employed is defined as total assets less current liabilities.
(Calculating capital in this way leads to an alternative name for ROCE: return on net assets).
Return on capital employed (ROCE)

Profit before interest and tax (PBIT)
ROCE = × 100
Capital employed
Profit before interest and tax, or profit from operations, is profit available for all holders of capital (shares and
loans). Capital employed is defined as total assets less current liabilities.
ROCE can also be defined as return on net assets.
Return on net assets
Operating profit (before interest and tax)
Return on net assets = × 100
Total assets minus current liabilities
Note that interest is deducted as a cost when accounts are prepared so, to calculate PBIT from a set of accounts,
you would have to add back to profit before tax the amount of any interest paid. Total assets and current
liabilities are shown as such on balance sheets prepared in accordance with international standards, so you should
have no difficulty in arriving at the figure for capital employed. This sum should be equal to equity plus the nominal
value of any outstanding loans.
5.1.2 Example: ROCE

In 20X8, Snoxall plc paid bank interest of $21,909 and earned profit before tax of $225,102. Total assets less
current liabilities were $751,969. Calculate ROCE for 20X8.
If the corresponding figures for 20X9 were $18,115; $342,130 and $988,899, what would ROCE have been for
20X9?
20X9 20X8
$ $
Profit on ordinary activities before tax 342,130 225,102
Add back: Interest payable 18,115 21,909
PBIT 360,245 247,011
Solution
20X9 20X8
360,245 247,011
ROCE =
988,899 751,969
= 36.4% 32.8%
This exercise illustrates a common use of measures such as ROCE: the making of comparisons between one year
and another. We cannot really comment on the size of Snoxall plc's ROCE unless we know something about what
is normal for its industry, but we can definitely say that it has improved between 20X8 and 20X9.
Assessment In the simple example above, we have calculated individual capital employed figures for each year. However, in
focus point your assessment, if you are asked to calculate ROCE and you are given two years' worth of capital employed
figures, you should use an average capital employed figure for the later year.
So, based on the figures from our example above, ROCE for 20X9 would be calculated as:
PBIT = $360,245
Capital employed: average of $751,969 and $988,899 = $870,434
$360,245
ROCE = = 41.4%
$870,434
5.1.3 Earnings per share

Earnings per share (EPS) is usually regarded as a measure of how well the company has performed for its equity
shareholders specifically, rather than providers of capital generally. (ROCE is a more general measure of the overall
productivity of capital.)
EPS is usually calculated as the profit available to equity shareholders divided by the number of equity shares in
issue. Note that a company is likely to have far more shares authorised than issued; it is the number of shares
actually issued to shareholders that we are interested in here. The total number of shares in the authorised share
capital is not relevant here.

CIMAFundamental of Business Economics Study Text - Decrypted

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CIMAFundamental of Business Economics Study Text - Decrypted

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by abruptsharp at www.free-ebook-download.

For assessments in 2010 and 2011

In this February 2010 edition

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Part A The goals and decisions of organisations

Part B The market system and the competitive process

Part C The financial system

Part D The macroeconomic context of business

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Paper C4 Fundamentals of Business Economics

C4 A – The goals and decisions of organisations – weighting 20%

C4 D – The macroeconomic context of business – weighting 30%

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Topic list Learning outcomes Syllabus references Ability required

1.1 Economics as a social science

4 1: The economic problem ⏐ Part A The goals and decisions of organisations

1.2 Scarcity of resources

Part A The goals and decisions of organisations ⏐ 1: The economic problem 5

1.3 The production possibility curve

6 1: The economic problem ⏐ Part A The goals and decisions of organisations

Question Production possibility curve

Part A The goals and decisions of organisations ⏐ 1: The economic problem 7

Answers to quick quiz

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8 1: The economic problem ⏐ Part A The goals and decisions of organisations

Topic list Learning outcomes Syllabus references Ability requ ired

1.1 The public and private sectors

1.2 Private sector organisations

1.2.1 Non-profit organisations

1.3 Public sector organisations

1.4 Primary, secondary and tertiary sectors

1.4.1 The primary sector

1.4.2 The secondary sector

1.4.3 The tertiary sector

2 The objectives of firms

2.1 The firm

2.3 Agency theory and the principal-agent problem

2.3.1 Resolving the agency problem

2.4 Alternative managerial goals

2.5 Baumol's sales maximisation model

2.6 Williamson's management discretion model